How to Prepare Financial Statements for an IRS Field Audit

Overview

An IRS field audit is an in-person examination of records at your place of business or your representative’s office. Unlike a correspondence audit (where the IRS requests documents by mail), a field audit gives the examiner direct access to books, records, and personnel. Preparing financial statements for a field audit is about more than good accounting: it’s about making your numbers transparent, defensible, and easy to verify.

I am a CPA with 15 years of experience helping individuals and small businesses through audits. In my practice, thorough preparation and a focused evidence package reduce examiner questions, shorten audit time, and often avoid proposed adjustments.

(Authoritative sources: IRS — Recordkeeping; IRS — Understanding the audit process.)

Step-by-step preparation checklist

Prepare these items before the examiner arrives. Organize them in a binder or indexed digital folder so you can hand over a clean package.

1. Executive summary (1–2 pages)

• A brief cover letter that describes the business, year(s) under exam, accounting method (cash or accrual), and any major transactions (asset sales, loans, owner draws, change of accounting method).

1. Financial statements

• Income statement (profit & loss) for the tax year(s) under audit and comparative periods.
• Balance sheet as of the tax year-end.
• Cash flow statement or a simple cash-basis summary if the business uses cash accounting.

1. Reconciliations and supporting schedules

• Bank reconciliations for each business bank account.
• Accounts receivable aging and supporting invoices for large balances.
• Accounts payable listing and vendor invoices for material items.
• Inventory counts and costing method support (if applicable).
• Fixed asset schedule with purchase dates, cost, accumulated depreciation, and disposition details.

1. Transaction-level support

• Sales invoices, merchant processor reports, daily cash summaries, deposit slips.
• Receipts for expenses, supplier invoices, payroll reports, Form 1099s and W-2s.

1. Tax-specific items

• Prior-year tax returns and adjustments.
• Forms supporting deductions and credits (e.g., Form 8829 for home office, Form 4562 depreciation schedules).

1. Internal controls and policies

• Bank authorization list, petty cash policy, and internal reconciliation procedures.

1. Communications log

• Record of communications with your CPA, tax preparer, and any written correspondence with the IRS.

What the IRS examiner focuses on

Examiners look to verify three things: that reported income is complete, that deductions are ordinary and necessary, and that assets & liabilities reconcile to records. Their first requests often include bank statements, ledger printouts, payroll records, and supporting invoices. Being proactive in providing reconciliations for those items reduces repetitive requests.

How to prepare each financial statement

• Income statement (P&L): Provide a month-by-month detail and a reconciled general ledger to the tax return amounts. Add supporting schedules for any large line items (contract labor, advertising, meals & entertainment).

• Balance sheet: Create schedules for cash, receivables, inventory, prepaid expenses, fixed assets, loans payable, and owner equity. Explain unusual year-end balances—e.g., intercompany transfers, related-party loans, or large uncollected receivables.

• Cash flow statement: If you use cash accounting, convert your P&L into a cash schedule that traces deposits and checks cleared. For accrual-basis businesses, show adjustments for receivables, payables, and inventory movements.

Reconciliations: the examiner’s favorite shortcut

Monthly bank reconciliations are among the most persuasive items you can show. A reconciled bank to book balance demonstrates control over cash and explains differences such as outstanding checks or deposits in transit. Prepare reconciliation printouts and the backing items (deposit slips, clearing checks, EFT confirmations).

Organizing the documentation package

• Use a logical folder structure: 00Cover, 01Financials, 02BankRecons, 03Receivables, 04Payables, 05Payroll, 06FixedAssets, 07TaxReturns, 08Misc.
• Number documents and provide an index so the examiner can cite the page number when requesting follow-ups.
• Provide both paper and indexed searchable PDFs. If paper-only is requested by the examiner, have duplicates ready.

Special schedules and explanations to include

• Owner compensation analysis showing reasonableness compared to industry norms.
• Related-party transaction summaries and intercompany loan documentation.
• Large one-time transactions: sale contracts, closing statements, loan agreements.
• Inventory valuation support (count sheets, costing method, shrinkage analysis).

Common red flags and how to address them

• Large cash deposits without matching sales records: prepare POS reports, daily cash logs, or merchant statements.
• Excessive owner draws or personal expenses coded as business: separate personal expenses and prepare a reimbursement schedule if appropriate.
• Understated payroll: provide payroll registers, payroll tax filings (Forms 941/940), and W-2s.

Working with a CPA or tax representative

Engaging a qualified CPA or enrolled agent is often the most effective way to handle a field audit. Your representative can:

• Communicate with the examiner and limit unnecessary disclosure.
• Prepare reconciliations and schedules in audit-ready format.
• Negotiate findings, propose reasonable adjustments, or prepare an administrative appeal.

I recommend executing an engagement letter that defines the scope (document prep, representation, and fees). If you plan to have representation during the examiner’s on-site visit, execute IRS Form 2848 (Power of Attorney and Declaration of Representative) in advance.

Day-of-audit practical tips

• Designate a single point person to meet the examiner and show records.
• Provide the executive summary and financial-package up front—this builds confidence.
• Don’t volunteer unnecessary explanations or ad-hoc stories; answer questions directly and provide documents requested.
• Keep a running log of what was provided and by whom (date, document set, signature).

Record retention guidance

General practice: keep supporting records for at least three years from the date you filed your tax return or two years from the date you paid the tax, whichever is later. Keep records for six years if you underreported income by 25% or more. Retain employment tax records for at least four years after the date the tax becomes due or is paid (see IRS guidance on recordkeeping).

(See IRS recordkeeping guidance: https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping)

How much detail is enough?

Provide enough detail to tie every tax-return line item to bank activity, invoices, payroll records, and supporting documents. Examiners don’t require perfect accounting systems, but they do require verifiable trails from tax return figures back to primary documents.

Common documentation templates to prepare (samples)

• Bank reconciliation template with columns for book balance, outstanding items, and adjusted balance.
• Fixed asset schedule template showing acquisition date, basis, accumulated depreciation, and depreciation method.
• Receivable aging with invoice links and dates collected.

Potential outcomes and resolution path

After the fieldwork, the examiner will issue:

• No change (your records supported the return), or
• Proposed changes (adjustments that increase tax or change basis), followed by a report and 30-day letter with options to agree, appeal, or request conference with Appeals.

If you disagree, you can request a conference with the IRS Office of Appeals or pursue collection due process after an assessment. A tax professional can evaluate whether to agree, negotiate, or appeal.

Links to related resources on FinHelp

• Preparing for a Field Audit: Documentation Checklist — https://finhelp.io/glossary/preparing-for-a-field-audit-documentation-checklist/
• What to Expect in a Field Audit — https://finhelp.io/glossary/what-to-expect-in-a-field-audit/
• Common Errors That Trigger IRS Field Audits for Small Businesses — https://finhelp.io/glossary/common-errors-that-trigger-irs-field-audits-for-small-businesses/

These pages include checklists and practical examples that pair well with the financial-statement preparation steps above.

FAQs

Q: How far in advance should I prepare?
A: Start as soon as you receive notice. If possible, assemble the package within two weeks—some complex items may take longer.

Q: Will the IRS accept electronic documents?
A: Many examiners accept indexed PDFs and spreadsheets; confirm with the assigned examiner in advance. Maintain originals until the audit is closed.

Q: How long does a field audit take?
A: Simple audits can take a few days; complex audits may require weeks of on-site work plus follow-up. Preparation shortens both on-site time and follow-up cycles.

Final notes and professional disclaimer

Prepared financial statements and well-indexed support materially improve audit outcomes. As a CPA who has represented clients in numerous field audits, I’ve seen well-prepared packages reduce proposed changes and speed resolution. This article is educational and does not replace personalized tax advice. For advice specific to your facts, consult a qualified tax professional or CPA. For IRS guidance on recordkeeping and audits, see the IRS’s recordkeeping page and guidance on the audit process.

Sources & further reading

• IRS — Recordkeeping: https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping
• IRS — Understanding the audit process: https://www.irs.gov/individuals/understanding-the-audit-process

(Last reviewed: 2025).